OPTIONS
Profiting In Sideways And Breakout Markets
Calendar Ratio Backspread
by Jeff Neal
Would you be interested in a trading strategy that has limited risk,
unlimited profit potential, is adjustment-friendly, and can profit in a
sideways or breakout-type market? Of course you would! Here's a look at
the calendar ratio backspread strategy.
The calendar ratio backspread is an options strategy that can be constructed using either puts or calls, depending on the trader's directional bias.
While the strategy may sound complex, using it is fairly simple.
CALENDAR RATIO BACKSPREAD DEFINED
As the name suggests, the calendar ratio backspread combines a standard
ratio backspread and a diagonal options strategy. For example, when using
calls, the standard ratio backspread involves purchasing calls with a higher
strike price and selling fewer calls with a lower strike price at little
or no cost - or even a credit. The ratio of calls purchased to those sold
is generally less than 0.67. The most common ratios are 1 to 2 and 2 to
3. This means buying two calls offset by selling one call, or buying three
calls against selling two.
The ratio backspread is usually implemented at little or no cost or
sometimes even for a credit, because the premium received from selling
the calls is often equal to or greater than the price paid for the long
options. The risk in this position is limited and equal to the number of
short calls, multiplied by the difference in strike prices, times 100,
and minus the net credit (or plus the net debit). The potential reward
is unlimited. Another important characteristic is that the standard ratio
backspread is constructed with strike prices all within the same expiration
months.
Putting together a diagonal spread consists of both the sale and the
purchase of an equal number of calls or puts with the same underlying security,
different strike prices, and different expiration dates. Shorting the front-month
option and hedging it by going long an option that expires at a later month
creates a diagonal spread. The anticipated directional bias of the market
is a strong factor in determining which strike prices to use. The maximum
risk of a diagonal spread is equal to the net debit of the options.
Merging the standard ratio backspread and the diagonal spread involves
selling shorter-term options and buying more longer-term options. The marriage
of these two strategies creates the calendar ratio backspread.
...Continued in the October 2003 issue of Technical Analysis
of STOCKS & COMMODITIES
Excerpted from an article originally published in the October 2003
issue of Technical Analysis of STOCKS & COMMODITIES magazine. All rights
reserved. © Copyright 2003, Technical Analysis, Inc.
